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Overcoming the Debt Trap

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Dean Baker
Truthout, June 7, 2010

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The deficit hawk gang is again trying to take our children hostage with new threats of enormous debt burdens. As in the past, most of what they claim is very misleading, if not outright false.

First and foremost, the basis of the bulk of their horror story has nothing to do with spending being out of control, but rather a broken private health care system. If per person health care costs were comparable to the costs in any other wealthy country we would be looking at long-term budget surpluses, not gigantic deficits. This would lead honest people to focus their energies on fixing the U.S. health care system, but not the deficit hawk gang.

But there is another part of their story that contains some truth. The government is borrowing large amounts of money right now to sustain demand in the wake of the collapse of private sector spending following the deflation of the housing bubble. If the deficit continues on the projected path, the country will substantially increase its debt burden over the course of the decade.

A higher debt burden will imply much larger transfers from taxpayers to bondholders in future years. This will require either higher taxes or cuts in other spending. Alternatively, the government could run larger deficits. However, in a decade or so, if the economy is again near full employment, higher deficits will either lead to higher inflation if the Fed opts to accommodate the deficits, or higher interest rates, if it targets a low rate of inflation. The latter could crimp investment and long-run growth. For these reasons, it is desirable to prevent the debt from reaching the levels now projected, even if the outcome may not be the disaster promised by the deficit hawks.

There is a simple way to avoid a sharp rise in the interest burden associated with a higher debt. The Federal Reserve Board can buy and hold the debt that is currently being issued by the Treasury to finance the deficit. The logic of this is straightforward. If the Fed holds the debt, then the interest on the debt is paid to the Fed. The Fed then returns the interest to the Treasury each year, meaning the net cost to the government is zero.

This is not slight of hand. The point is that the economy has a huge amount of idle resources in the form of unemployed workers and excess capacity. In this situation, the increased demand created by government spending does not have to come at the expense of existing demand. The economy can simply expand to fill the additional demand created by larger deficits. While that may not be true in five or ten years, assuming the economy is again near full employment, right now deficits need not lead to either higher interest rates or higher inflation.

In fact, the financial markets and the “bond market vigilantes” should even support the decision to have the Fed purchase and hold the government debt being issued now to finance the deficit. This practice will lessen the future interest burden on the Treasury. In fact, interest should be seen as an entitlement like Social Security and Medicare since it is paid each year without new authorization by Congress. If the deficit hawks had any integrity they would be insisting that we should require the Fed to hold the government debt issued during this downturn. It is a surefire way to substantially reduce entitlement spending.

Of course no one ever accused deficit hawks of being consistent. Not only do they not advocate having the Fed buy and hold the debt, they don’t even want this policy discussed in their “everything is on the table” sessions. Keeping this simple solution off the table makes good sense if your concern is not deficit reduction, but rather cutting Social Security, Medicare and other important social programs.

Fortunately, the rest of us don’t have to be bound by the deficit hawks’ agenda. If Social Security and Medicare are on the table, then having the Fed hold the debt better be on the table; otherwise this exercise is just a charade to cut the country’s most important social programs.

This will be a great lie detector test. We will soon know whether the “deficit hawks” care about the interest burden on our children or just want to destroy the social safety net.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The End of Loser Liberalism: Making Markets Progressive. He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues.